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The Fed And Investors Will Be Taking Cues From An Unbridled Yield Curve In 2016

Robert Keiser

The upcoming final Federal Open Market Committee (FOMC) meeting of 2015 (Dec. 15 and 16) will give Federal Reserve Chair Janet Yellen one last chance to make good on her statement made on July 10: "I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy."

Regardless of the result of the Fed's upcoming meeting, Global Markets Intelligence (GMI) is much more concerned with the direction of U.S. interest rates in 2016. To this end, we continue to believe that the FOMC needs to commence the normalization of U.S. monetary policy, effectively disconnecting the bond market "from the tethers of Fed indecision."

The Fed has exerted an enormous influence on bond market yields since it first began buying U.S. mortgage-backed and government securities to shore up the financial system during the darkest moments of the financial crisis in late 2008.

Through prolonged security purchases the Fed expanded the U.S. monetary base to $4 trillion today from $850 billion at the start of September 2008. The Fed then kept a lid on U.S. bond yields via the multi-year extension of the accommodative zero interest rate policy after open market security purchases concluded by the end of 2014.

Even now, the extremely cautious nature of most FOMC voting members has reinforced global investors' longstanding lack of fear of the Fed, which has helped flatten the U.S. Treasury yield curve since mid-year 2015 despite the increasing likelihood of a preliminary rate hike at the next meeting.

The yield spread between the 10-year and two-year Treasury notes continues to hold within the 2015 range established earlier this year between the low of 119 basis points (bps) set on Feb. 2 and the year's high of 177 bps recorded on June 26 and July 10. This yield curve has flattened by 47 bps to 124 bps at the start of December from 171 bps at mid-year.

We believe that if this yield spread begins to narrow below 120 bps, there could be little reason for the Fed to quickly follow up on the prospective lift-off of policy normalization at the December FOMC meeting. Alternatively, a curve steepening above the 147.5 bps mid-point of the current range could suggest the need for a timely follow-up adjustment of monetary policy. Any sustained steepening above the 2015 high watermark of 177 bps could hint that investors feel that the Fed is behind the curve and in need of a more aggressive normalization timetable (see chart).

We agree with the majority of market participants and many FOMC members that the time has finally come for the Fed to stop talking about normalizing monetary policy and to actually do it. After deliberating a rate hike for the past two years, any further delay could begin to tarnish Fed credibility.

The multiple crosscurrents within the U.S. economy aside, including strong job creation but recently soft consumer confidence, the accumulation of economic data this year suggests that it has now become difficult to justify the continuation of emergency monetary stimulus. A single 25 bp rate hike will be meaningless to the $16.4 trillion GDP U.S. economy that has grown by an average of 2.2% since exiting the recession in the third quarter of 2009, as opposed to the average 3.25% GDP growth that occurred in the 67 years preceding the great recession.

In the coming year, GMI believes that the sustained trajectory of job creation, wage growth, and the resulting rate of core inflation will dynamically influence the slope of the Treasury yield curve. In turn, this will send important signals to both the FOMC and investors about the prospect of subsequent adjustments to U.S. and perhaps even global monetary policy in the years to come.